Pareto optimality is an economic condition in which resources cannot be redistributed to make one person better without making at least one person worse. It implies that resources are allocated in the most efficient manner, but does not imply equality or justice.
Founder
Optimality is named after Wilfredo Pareto (1848-1923), an Italian engineer and economist who used this concept in his studies of economic efficiency and income distribution. Pareto efficiency has been applied in such academic areas as economics, engineering, and life science.
Pareto concept overview
There are two main questions of Pareto optimality. The first concerns the conditions under which the distribution associated with any competitive market equilibrium is optimal. The second refers to the conditions under which any optimal distribution can be achieved as a competitive market equilibrium after using lump-sum transfers of wealth. The resolution of these issues depends on the context. For example, if a change in economic policy eliminates the monopoly, and this market subsequently becomes uncompetitive, the benefits to others may be significant. However, since the monopolist is disadvantaged, this is not an improvement to Pareto.
In economics
The economy is in an optimal state according to Pareto, when no further changes in it can make one person richer, while not making the other poorer. This is a socially optimal result achieved in a perfectly competitive market. The economy will be effective provided complete competitiveness and a static general equilibrium. When the price system is in equilibrium, the marginal revenue product, opportunity costs, and the cost of a resource or asset are equal. Each unit of goods and services is used most productively and in the best way. No transfer of resources can lead to increased returns or satisfaction.
In production
Pareto optimality in production occurs when existing factors are distributed between products in such a way as to increase the output of one product without reducing the output of another. This is similar to firm-level technical efficiency.
There are many situations in which you can increase the total volume of production in the economy by simply redistributing productivity factors at no additional cost. For example, if the agricultural sector employs a lot of unproductive, low-paid labor, and in the industrial sector, where labor productivity is potentially high, there is a shortage of labor, then factory owners will raise labor prices and attract them from the agricultural sector to the industrial one.
Production efficiency arises when the combination of products actually produced is such that there is no alternative combination of products that would increase the welfare of one consumer without reducing the welfare of another.
Pareto in practice
Besides being used in economics, the Pareto improvement concept can be used in many scientific fields where compromises are modeled and studied to determine the amount and type of redistribution of variable resources needed to achieve efficiency. Thus, plant managers can conduct tests during which they redistribute labor resources in order to try to increase the productivity of assembly workers, not to mention the decrease in productivity of packaging and shipping workers.
A simple example of Pareto optimality: there are two people, one with a loaf, the other with a piece of cheese. Both can be done better by exchanging products. An effective exchange system will allow for the exchange of bread and cheese until one of the parties improves without worsening the situation of the other.
Game theory
Pareto optimality answers a very specific question: “Can one result be better than another?” An optimal game result cannot be improved without harming at least one player. To illustrate this, you can take a game called “Deer Hunting,” in which two people participate. Everyone can individually choose a deer or a hare for hunting. In this case, the player must choose an action, not knowing the choice of another. If a person hunts a deer, he must cooperate with his partner to succeed. A man can get a hare on his own, but he is cheaper than a deer. Thus, the game has one result that is Pareto optimal. It consists in the fact that both players hunt deer. With this outcome, they get three wins, which is the largest possible prize for each player.
Pareto Rule
The Pareto 80/20 Principle states that for many events, approximately 80% of the consequences stem from 20% of the causes. Vilfredo Pareto noted this connection at the University of Lausanne in 1896, publishing it in his first work Cours d'economie politique. In essence, he showed that approximately 80% of the land in Italy belongs to 20% of the population. Mathematically, rule 80/20 is followed by a power law distribution (also known as a Pareto distribution) for a specific set of parameters. It has been experimentally shown that many natural phenomena exhibit such a distribution. The principle is only indirectly related to Pareto optimality. He developed both concepts in the context of the distribution of income and wealth among the population.
Equilibrium theory
Pareto optimality leads to maximization of the total economic well-being for income distribution and a certain set of consumer preferences. A shift in the distribution of income changes the income of individual consumers. As their income changes, so do their preferences, as the demand curves for various products shift to the left or right. This will lead to a new equilibrium in the various markets that make up the economy. Thus, since there are an infinite number of different ways of distributing income, there is also an infinite number of different optimal Pareto equilibria.
findings
Obviously, in practice, no economy can be expected to achieve an optimal position. In addition, the Pareto principle is practically not used as a policy tool, since it is rarely possible to develop one that would make someone better without making someone worse. Nevertheless, this important concept in the neoclassical tradition of economics unites most of the theory. It is also the standard by which economists can explore the real world, where making one person better almost always means making someone else worse.